The EDHECinfra/G20 survey of infrastructure benchmarking practices, which included representatives of 130 asset owners accounting for $10 trillion, has found that existing performance monitoring benchmarks are self-defeating for asset owners and managers. But improvement, in the form of a more representative, better defined benchmarks, may be possible thanks to recent progress. This is the second in a three-part series examining the results of the survey.

Performance-monitoring benchmarks differ from the asset-allocation benchmarks insofar as they should represent actual investment choices made when implementing a fund’s investment policy.

In the case of infrastructure, the difference between policy and performance-monitoring benchmarks is all the more significant in that the ability to implement any given style or tilt is itself uncertain: infrastructure markets are notoriously illiquid and in part driven by public procurement and other policy decisions that are not easily predicted.

The implementation of a broad policy allocation to infrastructure may take multiple incarnations: different levels of geo-economic, industrial, or business-risk exposures are likely to require dedicated sub-allocations and will be fully known only after the fact. For instance, the high degree of specialist industrial knowledge required to make investments in any infrastructure sector usually militates for individual sub-strategies or mandates.

Perhaps even more importantly, building large, well-diversified positions in any segment of the unlisted-infrastructure space remains difficult today, given the average time and size of individual transactions.

As a direct result, while policy benchmarks focus on long-term rewarded risks, performance-monitoring benchmarks may require being tailored to an investor’s or their manager’s actual portfolio, and achieving sufficient granularity is very important to benchmark the investments made fairly and accurately.

As discussed in the first part of this series, in a core-satellite context (no relation with ‘core infrastructure’), investors can monitor and manage the performance of asset managers and investment teams by defining a core portfolio which is representative of the expected behavior of a given investment style or strategy and a satellite portfolio defined in terms of its tracking error relative to the core.

In the case of highly illiquid asset classes like unlisted infrastructure in which a well-defined ‘core’ is not directly investible, this distinction remains valid because it gives investors a way to monitor the dual objective given to asset managers: to deliver the core strategy (deal by deal) and to outperform the average as captured by the core benchmark.

An implementation of this approach to monitoring unlisted infrastructure managers can make use of the tracking error given to a manager as a representation of the construction of the infrastructure portfolio: the younger the portfolio, the larger the tracking error. As a portfolio of infrastructure debt or equity increases in size and representativeness, the tracking error should be reduced to only represent the space within which the manager can deliver alpha.

In the 2019 EDHECinfra/G20 survey, 50 per cent of respondents declared using the same benchmarks for performance monitoring as they do for strategic asset allocation and around 75 per cent of infrastructure equity investors reported using absolute benchmarks for performance monitoring.

In light of the comments above, this is highly problematic. While absolute benchmarks can be a good indicator of target returns, in order to monitor performance adequately investors should use a benchmark that represents their choice(s) of investment policy explicitly defined in terms of risk profile.

In effect, the practices described by investors in this survey correspond more to the definition of a hurdle rate rather than a benchmark.

About 70 per cent of respondents acknowledged that the benchmarks they use for performance monitoring do not allow investors to measure risk-adjusted performance.

When the same question was asked to asset owners only, more than 75 per cent of respondents reported similar concerns.

Almost 40 per cent of respondents also agreed that the use of another asset class as a proxy for unlisted infrastructure equity is a challenge.

Close to 30 per cent of respondents also acknowledged that current private benchmarks tend to report smoothed returns i.e. not to capture risk exposures.

Around 30 per cent of asset owners also said that current industry-peer, money-weighted benchmarks do not allow for a fair comparison of asset managers. Indeed, such indices are sensitive to the timing of cash flows, which can vary across fund managers and can even be manipulated to achieve higher returns.

In this survey, nobody liked their performance monitoring benchmark and would like to use a more representative, better defined benchmark that is informed by actual market movements and risk factors.

As in other alternative asset classes, asset owners and managers have long been at odds when it comes to demonstrating value and performance with illiquid asset classes like infrastructure. Managers say they have better deal making skills, while asset owners point to their high fees.

As is well documented this has pushed a number of large asset owners to internalise infrastructure investment decisions because they believe they would be better off investing directly in infrastructure than through third parties.

However, as the answers to the survey demonstrate, asset owners still do not know where they stand when it comes to infrastructure investing because they do not use representative, mark-to-market benchmarks that take their actual strategy and risk exposures into account. Their internal investment team continue to report the same ill-suited metrics they used to get from external managers.

Delivering a portfolio of unlisted infrastructure asset in line with a given mandate is hard work and requires skills, time and commitment, whether executed through a manager or internally. As discussed above, delivering the ‘core’ portfolio (as in ‘core-satellite’) creates value and justifies rewarding managers or investment teams.

Furthermore, the lumpiness and average size of infrastructure assets means that even a reasonably well-delivered core portfolio still offers opportunities to create alpha through asset selection and operation.

Hence, a customized benchmark that would represent a well-defined investment policy or strategy would help investors determine the value created by the manager or team that creates this portfolio, as well as measuring any outperformance relative to this strategy. In this context, managers can demonstrate the value they create twice: by creating a portfolio that tracks a well-defined benchmark and by outperforming it.

The EDHECinfra indices released quarterly from June 2019 onwards can help achieve the objective of better defining and benchmarking individual investors goals and asset managers value creation in unlisted infrastructure investments.

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